A look at Livestock Gross Margin for Dairy, ethanol and feed costs to help you prepare for the coming year.

By Marvin Carlson, Dairy Gross Margin, LLC

Key issues bring good questions, which aren’t always easily answered:

• USDA/RMA did use $13.2 million of the subsidy for Livestock Gross Margin–Dairy. No more subsidy money will be available until October 2013, unless this pilot program is changed by congress or in the 2012 farm bill. Can it be moved off of pilot status? Can the farm bill increase the subsidy or take off the cap? Can the industry agree on a risk management plan that is equitable for everyone? All good questions, with no good answers.

• Scott Brown presented “Ethanol’s Long Shadow” Nov. 8, 2011. What has ethanol done for you lately? What will ethanol do for you in the future? What won’t the coming changes for the ethanol blender’s tax do for you in the future? Look at the charts from Dr. Brown’s presentation.

• What will the coming ethanol changes do for future corn prices? Here is a quick look at some of the FAPRI model’s predictions.

Here are a few simple steps to help make the process a little easier for everyone.

By Katie Krupa, Rice Dairy

Many individuals struggle with making risk management decisions for themselves or their own personal business. The process frequently becomes even more difficult when multiple business partners are involved in making risk management decisions.

Here are a few simple steps to help make the process a little easier for everyone.

1. Set a goal. It is very important to set a goal for your risk management strategies. For any business, the goals should be driven by the business objectives and financial situation. Many farms set a goal to return a profit or protect their break-even. When utilizing a risk management strategy, there will inevitably be times when your farm price is above the actual cash price, and times when it is below the actual cash price. When the actual cash price is higher than the hedged price and some upside opportunity is missed, many people start to question and regret their strategy. Setting a clear, logical goal relative to your farm’s financials will help keep everyone on board with the strategy, regardless of the actual cash price. It is important to write down your goals and review them periodically.

2. Get the right people involved. Is your wife the one who receives the milk checks and manages the books? If she is, she should be part of the goal-setting discussion and the decision. Many farms I work with have a management team meeting, which includes the on-farm management staff and frequently the key consultants or agribusiness professionals, such as the lender, the accountant, nutritionist, etc. Agribusiness professionals can frequently offer unbiased advice and help make sure the decisions being made are truly in the best interest of the dairy.

3. Walk through several scenarios. Many times dairies will enter into a contract because they think they know what the market will do. They tend to say things like, “The milk price won’t move any higher,” or “No way we’ll see prices that low again.” Unfortunately, no one knows what tomorrow will bring and where the milk price will end up. That is why we have risk management – to protect against the unknown. A simple exercise is to walk through the desired risk management strategy at various cash prices. For example: With this strategy, what happens if the milk price goes to $10, and what happens if the milk price goes to $25?

4. Review your results. The results from your risk management strategy should meet the established goals. If they do not, analyze and find the problem. If they do, but you are not satisfied, look for alternative strategies that can meet your goals but have different attributes and potential outcomes. It may be necessary to work with an agribusiness professional to help complete the review.

5. Repeat. Your goals and strategies will most likely change over time, but you should be consistent in your use of risk management. Repeat steps 1-4 annually or several times per year depending on your situation. It is important to keep in mind that there may be a time when your risk management strategy is to be on the cash market. What I mean by that is, you are actively not placing any hedges but just taking the cash price that is announced each month. Either way, it is important to consistently review your goals and strategies and make sure you are protecting your business.

If your operation struggles to make risk management decisions, I suggest following these steps and working with a professional to help keep the team on track and make sure the decisions being made are in the best interest of the dairy. Make good, long-term financial decisions, try your best to avoid fear and greed, and your risk management strategies (and your business) will be successful.

Katie Krupa is the Director of Producer Services with Chicago-based Rice Dairy, a boutique brokerage firm offering guidance, analysis, and execution services on futures, options, spot and forward markets. If you are interested in learning more, Katie offers monthly webinars on the basics of risk management. You can reach Katie at klk@ricedairy.com.Visitwww.ricedairy.com.

As producers complete farm budgets for 2012, proactive marketing strategies can not only defend but help achieve goals. There are Class III hedging opportunities for all producers, regardless of location and utilization.

By Steven Schalla, Stewart-Peterson

‘Tis the season! The holidays are a wonderful time of the year full of family, friends, Christmas cookies, and New Year’s resolutions. There’s also something that’s likely on your to-do list that is not as warm and exciting as the holiday trimmings: completing the farm budget for the coming year.

Many of our clients have been sharing their cost of production results as an important component of their risk management planning. Moreover, our team has made a point to ask our clients what goals the operation has for 2012, both financially and otherwise. This is where designing marketing strategies becomes fun—when you’re not just looking to defend a breakeven price, but designing and implement a strategy to achieve the goals that allow the operation to thrive.

In our eyes, this is the most moving reason to pursue a strategic marketing approach: to control your own destiny in 2012. The concerns about milk prices in 2012 have been well discussed in the news, and the bottom line is that even the best forecaster doesn’t know for sure what will happen.

However, we can review today’s futures prices and determine what these values mean for your situation. We can even go a step further and analyze how changes in these prices would impact reaching your goals. These are important steps if you want to control your destiny. These steps put you in the driver’s seat, rather than always guessing what might happen and trying to react.

How to get it done

Now that I’ve given you the philosophy, let’s discuss how to do the analysis.

To achieve an understanding of how milk futures prices impact your situation, it is necessary to assess how your cash or “mailbox” milk price compares to the announced Class III value. This is the starting point in formulating a marketing strategy.

Here’s a question we get all the time: “What if I don’t produce a majority of Class III milk, is it appropriate to use Class III futures?”

The actual Class utilization for your milk is not important in this calculation. We are simply after the average difference between your milk price and Class III price, commonly referred to as the “basis.” So, it doesn’t matter whether you produce Class III milk or Class I milk. The correlation still works. Here’s an example:

The All-Milk Price represents a weighted average of “mailbox” prices dairy processors paid in a given month for all grade A and grade B milk. These monthly prices from the past 10 years are graphed on the chart below, along with the Class III announced prices over the same time frame.

With a simple eye-ball test, it is easy to see how closely these prices are related, and with some basic statistics, we can confirm this observation. If you are a wonky analyst like me, it is easy to calculate a correlation coefficient and illustrate, when you know the change of one variable (like Class III milk price), how accurately you can project what the change will be in a second variable (such as the All-Milk Price).

The relationship or correlation between the two variables is scored on a scale of -1.00 to +1.00. A score of greater than +0.50 or less than -0.50 in most applications is considered a strong correlation (with zero meaning no relationship can be concluded).

In our example with milk price, the correlation coefficient analysis between Class III prices and All-Milk Prices returns a score of +0.9676, confirming that there is a direct and very strong correlation between the two prices. If the Class III price is changing, it should be possible to project the related change in the All-Milk Price. While very strong, the correlation is not perfect and, in occasional circumstances, the changes between the two prices will not be exact. However, for a consistent, long-term milk marketer, this should not be a material issue.

This analysis illustrates why it is not necessary to produce Class III milk to use Class III futures. We’ve done this same study for individual farms across the country, and results demonstrate the strong correlation every time. Then, we just need to understand the typical “basis,” or difference between your mailbox price and the Class III price.

Referring back to the chart above, we can calculate the basis of the All-Milk Price by subtracting the Class III price for each respective month. Over the past ten years, the All-Milk price has averaged $1.31/cwt. over the Class III price, or in other words, the All-Milk Price has a positive average basis of $1.31/cwt. This is the critical first piece of information needed when working to understand how Class III hedging strategies relate to your milk price and reaching your operations goals.

The Class IV Futures

It’s also noteworthy that Class IV Milk futures are available along with Class III futures. It makes logical sense that hedging Class IV production with Class IV futures would be superior to using Class III futures. The very low volume of trade in the Class IV market, however, can present additional challenges.

To put this in perspective as we work through our 2012 marketing strategies, the table below lists the Class III and Class IV futures contract and their respective Open Interest in early December. Open Interest is the total number of contracts outstanding, or being held, by all market participants. As you can see, the Class III total open interest is over 14 times that of the Class IV futures.

Low volume does not make it impossible to use the Class IV market. It does mean that users will have to use extra patience when working to get their orders done, or be willing to give in on price more to get orders done, and repeat the process in the need or desire to exit the position prior to expiration.

Using the same correlation coefficient analysis demonstrated above, Class III and Class IV prices score +0.8596, illustrating the direct and very strong relationship between the two prices. While not a perfect correlation, we place a high value on the ability to efficiently enter and exit hedging positions in a volatile and fast changing marketplace. Thus, in almost all cases, we recommend producers, particularly producers new to using these tools, utilize the Class III futures to achieve the optimal results.

In short, there are Class III hedging opportunities for all producers regardless of location and Class utilization.

·The first step is to find your average basis relative to the Class III price.

·Armed with this number, design your strategies and test the scenarios of different prices changes that could take place during the coming year. This is a process and requires a time commitment, but the satisfaction of meeting your goals makes it well worth the investment.

·Of course, if you’re not comfortable with tackling this process yourself, or simply do not have the time, find a trusted advisor who will learn the details of your goals not only for the next year, but for the long run, to form a successful relationship.

Happy Holidays from the entire Stewart-Peterson family. May the potential of 2012 be fruitful, bearing happiness and success!

The data contained herein is believed to be drawn from reliable sources but cannot be guaranteed. Neither the information presented, nor any opinions expressed constitute a solicitation of the purchase or sale of any commodity. Those individuals acting on this information are responsible for their own actions. Commodity trading may not be suitable for all recipients of this report. Futures trading involves risk of loss and should be carefully considered before investing. Past performance may not be indicative of future results.Any reproduction, republication or other use of the information and thoughts expressed herein, without the express written permission of Stewart-Peterson Inc., is strictly prohibited. Copyright 2011 Stewart-Peterson Inc. All rights reserved.

2011 was a good, not great, year. Cycles, seasonal patterns and fundamentals have played out according to principle and rule, without surprise.

By Carl Babler, First Capitol Ag

Viewing forward commodity price and price opportunity is a requirement of a dairy marketer, and looking backward is typically the wrong approach.

However, a look backward at commodity market action, price behavior and fundamental conditions that have played out is helpful from an educational standpoint. With this in mind to better “Know Your Market,” I offer the following observations relative your 2011 dairy market.

2011 and the Three-Year Class III Milk Price Cycle

With 2009 observed as the obvious three-year Class III milk price cycle low year, the following cycle expectations were possible:

·2010 possible gathering recovery year

·2011 possible strong/cycle high year

·2012 possible weak/cycle low year

The 2011 price was strong with five different months announced above $19.00, including a record $21.67 price announced for August.

Seasonally each year there is an expected price direction for given periods of the 12-month calendar. A price low for the year was observed in the first quarter of 2011, and price moved directionally higher into third quarter of 2011.

Observation:The 2011 milk market followed its typical seasonal price pattern with an extended price rally into late November.

2011 and Supply and Demand Fundamentals

During the course of 2011, price and revenue improved and, as expected, cow numbers increased. The U.S. dairy cow herd total trended higher during 2011. To date, the herd numbers 9.219 million head, the highest number since June of 2009.

Observation:The 2011 milk market reflected production chasing higher prices with an increase in the cow herd.

2011 and Production Margin and Profitability

During 2011, even with price/revenue improvement, margins have been modest. Income over feed cost has spent the entire year to date narrowly on either side of $9, the 10-year average USDA calculation.

Observation: Cow numbers and production expanded during 2011, even in the face of modest margins.

2011 and Dairy Exports

The U.S. dairy export value continued a positive trend, which started in early 2009, to record values through summer of 2011. The growing dairy export participation by the U.S. has been a very positive fundamental for your market in 2011. After three years of growth, we slowly have become somewhat dependent on export business as we have geared up production and processing to meet this additional demand.

With that said, the loss of a quarter or a third of this export trade, for any reason, would quickly result in a domestic oversupply.

Observation: Exports have been strong, but exports of cheese and butterfat have been declining recently.

2011 and Risk Management Strategies

With the opportunity to look backward, it is easy to identify which marketing strategies worked best in 2011. In a strong price year, marketers were well served by employing hedge strategies that allowed for some upside price opportunity.

Observation: The use of straight puts, option “fences” and long calls covering fixed price contracts or sold futures worked well. Obviously, selling milk forward with futures or on a fixed priced cash contract in a possible three-year price cycle, high-price year was a less favorable approach.

Conclusion: 2011 was a good, not great year. Cycles, seasonal patterns and fundamentals have played out according to principle and rule, without surprise. What lies ahead should also be viewed with cycles, patterns and fundamental principles clearly in mind. Thus, a case to “Know Your Market.”

Carl B. Babler is a consultant and senior hedge specialist with First Capitol Ag in Galena, Ill. He has been involved in the futures industry as a broker, educator and hedger since 1975. Babler holds master’s degree from the University of Wisconsin-Platteville and completed agribusiness course work at Harvard University. You can reach him at 1-800-884-8290 or cbabler@firstcapitolag.com.